The Ongoing Lender of Last Resort Debate

Two days do not a policy success make, and it is a fool’s game to tie the merits of a policy action to a short-term stock market cycle. But at first blush it does certainly appear that Wednesday’s announcement of coordinated central bank actions to provide liquidity support to the global financial system had a positive effect. The policy is described in the Board of Governors press release:

“The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank… have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013.”

“Under the program, the Fed lends dollars to other central banks, which in turn make the dollars available to banks under their jurisdiction. The action Wednesday made these emergency Fed loans cheaper, lowering their cost by half a percentage point.

“When the Fed launched the swap lines, it saw them as critical to its efforts to tame the financial storm sweeping the globe. Banks in Europe and elsewhere hold U.S. mortgage securities and other U.S. dollar securities. They get U.S. dollars in short-term lending markets to pay for these holdings. In 2008, when dollar loans became scarce, foreign banks were forced to dump their holdings of U.S. mortgages and other loans, which in turn pushed up the cost of credit for Americans.

“The latest action was at least in part an attempt to head off a repeat of such a spiral.”

It is at least interesting that this most recent Fed action occurs as criticism of its past actions to address the financial crisis has once again arisen. The immediate driver is another installment in a series of Bloomberg reports that parse recently released details from Fed lending programs during the period from 2007 to 2009.

I have in the past objected to the somewhat conspiratorial tone in which the Bloomberg folks have chosen to cast the conversation. I certainly do not, however, think it objectionable to have a cool-headed conversation on what we can learn from the Fed’s actions during the financial crisis and how it might inform policy going forward. Following on the latest Bloomberg article, Felix Salmon and Brad DeLong have taken up that cause.

“Intense strains in financial markets during the financial crisis severely disrupted the flow of credit to U.S. households and businesses and led to a deep downturn in economic activity and a sharp increase in unemployment. Consistent with its statutory mandate to foster maximum employment and stable prices, the Federal Reserve established lending programs during the crisis to address the strains in financial markets, support the flow of credit to American families and firms, and foster economic recovery.”

Neither Salmon nor DeLong argues with this assertion, and even the Bloomberg article includes commentary broadly supporting Fed actions, even if not all details of the implementation. More controversial is this observation from the Fed’s frequently asked questions (FAQs):

“The Federal Reserve followed sound risk-management practices under all of its liquidity and credit programs. Credit provided under these programs was fully collateralized to protect the Fed—and ultimately the taxpayer—from loss.”

Here is where opinions start to diverge. From DeLong:

“In the fall of 2008, counting the Fed and the Treasury together, a peak of 90% of Morgan Stanley’s equity—the capital of the firm genuinely at risk—was U.S. government money. That money was genuinely at risk: had Morgan Stanley’s assets taken another dive in value and blown through the private-sector’s minimal equity cushion, it would have been taxpayers whose money would have been used to pay off the firm’s more senior liabilities. ‘Fully collateralized’ the loans may have been, but had anything impaired that collateral there was no way on God’s Green Earth Morgan Stanley—or any of the other banks—could have come up with the money to make the government whole.”

And from Salmon:

“The Fed likes to say that it wasn’t taking much if any credit risk here: that all its lending was fully collateralized, etc etc. But it’s really hard to look at that red line and have a huge amount of confidence that the Fed was always certain to get its money back. Still, this is what lenders of last resort do. And this is what the ECB is most emphatically not doing.”

As Salmon’s comment makes clear, he does not view these risks as a repudiation of the appropriateness of what the Fed did during the crisis. And if I read Brad DeLong correctly, his main complaint is not about the programs per se, but on the pricing of the support provided to banks:

“When you contribute equity capital, and when things turn out well, you deserve an equity return. When you don’t take equity—when you accept the risks but give the return to somebody else—you aren’t acting as a good agent for your principals, the taxpayers.

“Thus I do not understand why officials from the Fed and the Treasury keep telling me that the U.S. couldn’t or shouldn’t have profited immensely from its TARP and other loans to banks. Somebody owns that equity value right now. It’s not the government. But when the chips were down it was the government that bore the risk. That’s what a lender of last resort does.”

I wish that we could stop commingling TARP and the Fed’s liquidity programs. At the very least, the legal authorities for the programs were completely distinct, and the Federal Reserve did not have any direct authority for the implementation of the TARP program. But that is probably beside the point for the current discussion. What is germane is the observation that the TARP funds did come with equity warrants issued to the Treasury. So in that case, there was the equity stake that DeLong urges.

As for the Fed programs, here again is a response taken from Fed FAQs:

“As verified by our independent auditors, the Federal Reserve did not incur any losses in connection with its lending programs. In fact, the Federal Reserve has generated very substantial net income since 2007 that has been remitted to the U.S. Treasury.”

This observation does not, of course, repudiate Felix Salmon’s point that losses may have been incurred, or the DeLong argument that the rates paid for loans from the Fed were not high enough by some metric. Nor should turning a profit be seen as proof that lending policies were sound (just as incurring losses would not be proof that the policies were foolhardy). But doesn’t the record at least provide some support for a case that the Fed used reasonable judgment with respect to its lending decisions and acted as prudent steward of taxpayer funds even as it took extraordinary measures to address the worst financial crisis since the Great Depression?

In fact, the main point raised by Felix Salmon is not that risks were taken, but that those risks were not communicated in a transparent way:

“And it’s frankly ridiculous that it’s taken this long for this information to be made public. We’re now fully ten months past the point at which the Financial Crisis Inquiry Commission’s final report was published; this data would have been extremely useful to them and to all of the rest of us trying to get a grip on what was going on at the height of the crisis. The Fed’s argument against publishing the data was that it ‘would create a stigma,’ and make it less likely that banks would tap similar facilities in future. But I can assure you that at the height of the crisis, the last thing on Morgan Stanley’s mind was the worry that its borrowings might be made public three years later. When you need the money, and the Fed is throwing its windows wide open, you don’t look that kind of gift horse in the mouth.”

One thing I wish to continually stress is that we should be clear about what Bloomberg refers to as “secret loans.” One last time from the Fed FAQs:

“All of the Federal Reserve’s lending programs were announced prior to implementation and the amounts of support provided were easily tracked in weekly and monthly reports on the Federal Reserve Board’s website.”

So the missing information was not about the sums of money being lent but the exact details of who was receiving those loans. In most cases, these loans were not targeted to specific institutions, but obtained from open funding facilities such as the Term Auction Facility. And, though you can argue the point, stigma was a real concern, as Chairman Bernanke has testified:

“Many banks, however, were evidently concerned that if they borrowed from the discount window, and that fact somehow became known to market participants, they would be perceived as weak and, consequently, might come under further pressure from creditors. To address this so-called stigma problem, the Federal Reserve created a new discount window program, the Term Auction Facility (TAF). Under the TAF, the Federal Reserve has regularly auctioned large blocks of credit to depository institutions. For various reasons, including the competitive format of the auctions, the TAF has not suffered the stigma of conventional discount window lending and has proved effective for injecting liquidity into the financial system.”

Salmon argues that this resolution to the stigma problem would not have been weakened by the current rules that require reporting the lending specifics with a lag. It is a reasonable argument (in what is, as an aside, a balanced and reasoned article by Salmon), and reasonable people can disagree. In any event, lagged reporting of details on the recipients of Fed loans is now the law. As a consequence, if such liquidity programs are needed again we can only hope that Felix Salmon’s beliefs turn out to be true.

Dr. David E. Altig is senior vice president and director of research at the Federal Reserve Bank of Atlanta. In addition to advising the Bank president on Monetary policy and related matters, Dr. Altig oversees the Bank's research and public affairs departments. He also serves as a member of the Bank's management and discount committees.

Dr. Altig also serves as an adjunct professor of economics in the graduate school of business at the University of Chicago and the Chinese Executive MBA program sponsored by the University of Minnesota and Lingnan College of Sun Yat-Sen University.

Prior to joining the Atlanta Fed, Dr. Altig served as vice president and associate director of research at the Federal Reserve Bank of Cleveland. He joined the Cleveland Fed in 1991 as an economist before being promoted in 1997. Before joining the Cleveland Fed, Dr. Altig was a faculty member in the department of business economics and public policy at Indiana University. He also has lectured at Ohio State University, Brown University, Case Western Reserve University, Cleveland State University, Duke University, John Carroll University, Kent State University, and the University of Iowa.

Dr. Altig's research is widely published and primarily focused on monetary and fiscal policy issues. His articles have appeared in a variety of journals including the Journal of Money, Credit, and Banking, the American Economic Review, the Journal of Economic Dynamics and Control, and the Journal of Monetary Economics. He has also served as editor for several conference volumes on a wide range of macroeconomic and monetary-economic topics.

Dr. Altig was born in Springfield, Ill., on Aug. 10, 1956. He graduated from the University of Iowa with a bachelor's degree in business administration. He earned his master's and doctoral degrees in economics from Brown University.